Expert: It’s tough for Islamic banks too

The industry saw strong growth in 2007 despite the start of the subprime crisis and was still expanding fast until the summer last year, when the credit crunch began to take its toll.

“This year the syariah banks are going to be exposed to the crisis the entire year. Those who survive this year will come out as winners, but others, especially the smaller banks, could merge, be taken over, or simply disappear,” BMB Islamic UK Ltd chief executive officer Dr Humayon Dar said in a media interview in Kuala Lumpur yesterday.

Islamic finance is distinctively different from conventional banking in principles. But it does not operate in isolation from the mainstream financial market and hence is not spared from the credit crunch, Humayon said.

Consolidation is a positive development for the industry since it will help pool the Islamic assets under fewer but stronger institutions, he said.

The Western banks are now more convinced about Islamic banking potential after they saw the sector’s resilience in the face of the subprime crisis.

On the other hand, some big financial institutions from the UK and the US, which entered the market four to five years ago in chase of the huge oil wealth, were disappointed by Islamic finance, he said, because they failed to secure business from syariah investors.

“It is very difficult for non-Islamic institutions to sell syariah banking products. The syariah investors are not going to trust someone who has conventional products in his left hand, Islamic products in his right hand and who sits in the bar drinking,” Humayon observed.

London-based BMB Islamic provides syariah structuring and advisory services to mainly financial institutions. It is part of the Cayman Islands-registered asset management firm BMB Group Ltd, whose parent is in Brunei.

BMB Islamic was recently named the Best Syariah Advisory Firm in Islamic Finance News Poll conducted by Kuala Lumpur-based Redmoney Group, and Humayon was in Kuala Lumpur to attend the award ceremony.

Derivatives dispute divides Islamic finance market

2009/02/11

Strict rules on transparency and simpler deal structures saved syariah lenders from the worst of the current credit crisis, but their ability to survive future shocks is in question because they have few instruments to guard against wild swings in currency and interest rate movements.

“To the extent there are not enough syariah-compliant liquidity and risk management products, then clearly Islamic finance would be disadvantaged compared to conventional banks and would be less able to manage their liquidity risks,” said Hussein Hassan, head of Islamic structuring at Deutsche Bank.

The US$1 trillion (RM3.59 trillion) industry bans banking structures that are vague or ambiguous to avoid exploitation – a rule which some argue shuts out the use of common hedging instruments such as currency and interest rate swaps and futures contracts.

But as more markets embrace Islamic finance and the need for risk protection increases, there are growing attempts to find syariah hedging tools.

More complex derivatives have come under widespread scrutiny by regulators and governments in the West for their role in the credit crisis. Some products have been blamed for spreading risks of bad assets rather than containing them and amplifying the impact of losses in the financial slump.

Derivatives were a prickly issue in Islam even before the US subprime mortage market collapsed. Reflective of the diverse interpretations of Islamic law, the industry is divided over the use of derivatives – and for different reasons.

This has left Islamic institutions with far fewer hedging devices than their conventional peers.

These suspicions have deepened with derivatives having evolved from relatively simple contracts such as foreign-exchange forwards to complex tools like credit default swaps, over-the counter-contracts between two parties that bet on whether a company will default on its bonds within a certain time.

The conventional credit derivatives market alone was estimated to be worth some US$55 trillion (RM197.45 trillion) by last October.

With derivatives seen as a key trigger for the financial crisis and ensuring global economic downturn, opinion in Islamic finance may have now swung in favour of the conservative view.

“Just as there are fewer takers for conventional derivatives, fewer Islamic investors are biting at Islamic derivatives,” said Hooman Sabeti, an Islamic finance lawyer with Allen & Overy.

“Similarly, new participants in Islamic derivatives with the fortitude to proceed are steering away from more controversial structures and embracing more conservative ones.”

Some syariah advisers, however, permit derivatives as long as they are used to hedge risks on existing investments and not for speculation.

The difficulties with this argument are clear.

“Islam encourages you to manage your risk,” said Agil Natt, chief executive of INCEIF, an Islamic university based in Kuala Lumpur. “But when does risk management end and gambling begin?”

Derivatives are also avoided as their underlying assets can be uncertain, as many loss-laden Western banks and investors have discovered.

“In Islamic law, there must be something tangible that you are selling,” said Mohammad Akram Laldin, a syariah scholar who sits on various syariah advisory boards including HSBC Amanah. “You cannot be selling something in which you do not know the status of the subject matter.”

Last year, CIMB Islamic, the world’s top arranger of Islamic debt, launched a forex hedging tool where investors enter into an Islamic transaction with the bank.

The net proceeds – which are similar to the premium paid for conventional options – gives investors the right to exercise the option at the agreed rate on the maturity date.

But some bankers say the industry is struggling to find enough Islamic contracts that can be used to create derivatives.

“Most of the contracts that we have today aren’t entirely and immediately transferrable towards structuring derivatives products,” said Deutsche’s Hussein.

“Apart from ‘arbun’, which is the contract that is used mostly to do options, it’s not immediately clear that we’ve got enough other contracts that can be used to do other things.” Under an arbun contract, a purchaser makes a deposit (which forms part of the purchase price) to buy particular assets at a later date. Should the sale not proceed, the seller keeps the deposit.

Another difficulty is that Islamic finance contracts are subject to varying interpretations due to different readings of the syariah.

The International Swaps and Derivatives Association is working on a template to standardise the main terms for over-the-counter syariah derivative contracts.

“In the Islamic market acceptance has to come from a wide range of independent syariah boards, which might be challenging,” said Mahmoud Abushamma, HSBC’s head of syariah division in Jakarta. – Reuters

Delegates at the Future Proofing Your Bank MEFX conference in Dubai on Sunday discussed the vexing issue of product development from an Islamic finance perspective. Standardisation was given the most attention, as it always seems to at conferences where Islamic finance is discussed, but how much progress is taking place with regards to the subject is still not certain.

Sanjay Vig, managing director of Alpen Capital, which was behind several high profile Sukuk, such as the Berber Cement Sukuk in Sudan and the Mobily telecoms issuance in Saudi Arabia, pointed out that the issue of standardisation was not just an issue between regions, but also sometimes between countries. He said that while the Mobily Sukuk was accepted in Saudi Arabia, it was not in the UAE.

Vig also said that sorting out the critical issue of uniformity was vital if Islamic finance wanted to become globally acceptable. Uniformity and replication of products would speed up the process because the complex documentation that is part and parcel of the current trend in Islamic finance was slowing down its spread. Any bank that became involved had to run the product past its Shari’ah board, which also added to the time it took to bring it to market. Uniformity would greatly speed up that process, he said.

Ghazanfar Naqvi, director of Islamic products for Saadiq in the UAE added that very few law firms in the region understood Islamic finance and he said they needed “to gear up” to be able to meet demand. One thing that would help product development, said Naqvi, would be if more conventional bankers moved over to Islamic banking. “You cannot teach banking to everyone, but you can teach Islamic [law],” he said.

Delegates were told that not more than 20 to 30 per cent of Islamic banks portfolios from the GCC are invested outside the region and that more diversification of risk was required. This, they were told, would also help to increase the awareness and popularity of Islamic finance.

Vig said that more international listings of Sukuk on exchanges like New York, Hong Kong and London would increase its visibility and he said would assure investors that by listing there, that they were meeting internationally recognised standards.

There was also talk among delegates about the role of Takaful in markets such as the UAE and Qatar where a huge real estate boom was taking place. Many wondered why Takaful had such a small share of the market, compared to conventional insurance, when so much money was being invested in real estate. Others expressed wonderment at why Islamic real estate investment trusts were not more popular, given that India, Pakistan and Malaysia were actively considering them.

The Difference Between Shari’a-compliant and Shari’a-based Islamic Finance Institutions
Natalie Schoon, The Bank of London & The Middle East – 22 Jan 2008

This article considers the subtle differences between the two key players within the Islamic finance industry – Shari’a-compliant banks and Shari’a-based banks – and how they could co-operate to achieve the real potential of this market.

On 9 July 2007, the Bank of London and The Middle East (BLME) was launched in London. BLME is the second wholly Shari’a-compliant investment bank authorised and regulated by the UK’s Financial Services Authority (FSA). This brings the number of fully Islamic banks in the UK to three, with the total number of financial institutions offering Islamic financial services in the UK at 24. Another three Islamic financial institutions are in the process of applying for a licence with the FSA, showing the strength of the UK as the largest Islamic finance hub outside Muslim geographies.

Although a young segment of the financial industry, Islamic finance has gone through an exceptional growth period. Over the past 10 years, the industry has grown at a rate of 15-20% per year. This level of growth is expected to continue in the coming years and by far exceeds the rate of growth in conventional finance. The increase in wealth resulting from the rise in oil prices and the subsequent requirements for investment in oil-producing countries is a large contributor to the expansion of the Islamic finance industry. Coupled with relatively high returns, this attracts banks and investors alike.

Islamic financial products are not only offered by fully Shari’a-compliant banks but also by conventional banks employing specific distribution channels, such as Islamic windows and Islamic branches. The issue that arises is whether Islamic financial products offered by a conventional bank are equally acceptable to Muslims as those offered by fully compliant Islamic financial institutions. There is, after all, a difference in the level of Shari’a compliance of conventional and Islamic banks.
Shari’a Supervision

Islamic financial institutions have an additional layer of corporate governance over and above the governance mechanisms in place for conventional financial institutions. In addition to a supervisory board, independent external auditors, adequate policies and procedures and other governance mechanisms, Islamic financial institutions also have to ensure compliance with the Shari’a principles, which are reviewed and monitored by the Shari’a Supervisory Board (SSB). The role of the SSB is to issue fatwa (opinions) setting out how the bank’s operations should be carried out in order to be consistent with Shari’a rules and principles (ex-ante compliance). In addition, because of its role within the corporate governance framework, the SSB is also responsible for the monitoring of the institution’s Shari’a compliance in applying the fatwa in practice (ex-post compliance).
Shari’a Compliance

In order for a financial product to be Shari’a compliant, it needs to satisfy, at a minimum, the criteria of Shari’a law regarding the avoidance of Riba, Maysir and Gharar. Once these are satisfied and the bank obtains Shari’a supervisory board approval, the product or structure can be marketed as Shari’a compliant. As far as conventional banks are concerned, this is where Shari’a compliance stops. It does not constrain the bank from employing non-Islamically raised funds to invest in Islamic structures.
Shari’a Based Banks

A fully Shari’a-compliant or Shari’a-based bank takes the compliance with Shari’a law a step further. Not only do individual products have to meet all requirements but also all operations within the bank are required to be compliant with Shari’a law. This extends to contracts with suppliers, rental contracts and labour contracts. The bank is completely set up to work in line with the ethical framework of Shari’a, which makes it more likely to be able to structure all products to meet the requirements. In addition, there is no co-mingling of conventional and Islamically raised funds, since all funds are raised in line with Shari’a requirements.
Impact on Investment Decisions

The decision any investor, depositor, Sukuk issuer or other client of a bank will have to make is related to the trade-off between the level of Shari’a compliance and the reputation and historic track record of the bank.

A large conventional bank with a proven track record will provide a relatively higher degree of certainty than a newly established Islamic bank. In addition, large conventional banks have the advantage of the backing of a big balance sheet and structuring capabilities that are well beyond the potential of Islamic banks, at least at the moment. This becomes immediately clear when comparing the total assets of the largest Islamic bank with total assets of large conventional banks. At the end of 2006, the largest Islamic bank (Al Rajhi) had total assets of US$28.1bn. The likes of HSBC, Barclays and Citi, on the other hand, each had a total asset base close to US$2 trillion at the end of December 2006.

As a result, it is much easier for conventional banks to underwrite large Sukuk issues and to structure sizeable project finance structures than it is for Islamic banks. Between June 2006 and June 2007, five of the 10 biggest Sukuk arrangers were conventional banks. Issuers choose conventional banks for their proven track record, their ability to raise large sums of money and, most importantly, their competitive pricing.

Conventional banks, however, provide Islamic finance as part of a broader range of financial products and although the individual offerings are Shari’a-compliant and the distribution channel is different from other financial products, a conventional bank is likely to co-mingle funds raised in an Islamic manner with conventionally raised funds. In addition, conventional banks can hedge positions using innovative financial products that are often not allowed in Islamic banks, given the speculative nature of the majority of hedging products.

A small, relatively young Islamic bank does not have a long track record and can hence be seen by investors and depositors as carrying a higher risk. Although some comfort can be found in the fact that the bank is regulated, conventional banks are regulated in the same way. As a result of the smaller balance sheet size, Islamic banks are not currently in a position to underwrite large Islamic finance transactions unless they are part of a syndication effort and, even then, some transactions are out of their scope due to large exposure regulations and size limitations.

On the other hand, a Shari’a-based bank operates completely within the remit of the ethical framework defined by Shari’a law, something that could be of significant interest for Muslims. A fully Islamic financial institution will not only be audited internally and externally, but will also be subject to an annual review by the Shari’a supervisory board as an independent third party to ensure ongoing Shari’a compliance for the whole of the business. An Islamic window or branch of a conventional bank does not necessarily go through this type of ex-post compliance audit, and in any case does not have to report the results in its annual report.
Compete or Co-operate?

There is a strong call in the market to form an Islamic ‘mega’ bank but given the size of the individual Islamic banks, this appears to be quite a way off.

Although the number of Islamic banks is growing exponentially, their balance sheet size on a consolidated basis is not even remotely close to the size of any of the large conventional banks on their own. Thus, the two types of players operate in different market segments, which actually make them very complementary. In the end, there is a place for both Shari’a-compliant and Shari’a-based banks. By working closely together, they can achieve high market penetration and work on reaching the full potential of the market.